What's Easy about Quantitative Easing?

Recently you may have read or heard in the news about the possibility of the Federal Reserve (Fed) "tapering" its Quantitative Easing (QE) program. The topic can be so ingrained in the news cycle that few newscasters may take the time to cover the details. So we thought we'd spend a few minutes discussing the background and recent developments on the QE program, and why it matters to investors.

Following the economic downturn of 2008, the US Federal Reserve has taken several steps to lower US interest rates. Key among these is a decision to set the target Federal Funds rate in the 0.00% to 0.25% range - as a reminder, the Federal Funds rate is the interest on bank excess reserves held at the Federal Reserve. This rate sets the tenor for determining short-term interest rates in the US, and has been at the same level since 12/16/2008. Given that the short term rate cannot be lowered any further, The Fed has also undertaken actions to lower long-term bond rates, via purchases of long term US Treasury bonds and mortgage backed securities. These purchases are known as Quantitative Easing, and they reduce the supply of long-term bonds, thus driving their prices upward, and lowering long term rates.

Lower interest rates make borrowing cheaper, and tend to spur more consumption and therefore increase economic activity. Lower long-term rates in particular drive increased demand for housing and construction, which tends to decrease unemployment and also reinforces price stability in housing.

The Fed has indicated that as the US economy improves, we should expect that the economic stimulus through a low rate policy will be gradually phased out. The expectation is that the QE bond buying will start to be slowly phased out (or "tapered"), followed by short term rates rising. This process is likely to take several years, with QE possibly winding down in late 2014 and short-term rates rising in 2015.

Comments made by Fed chairman Ben Bernanke in mid-May suggested that QE tapering may begin as early as September if new data on economic activity remained upbeat. This announcement caused the markets to react, and long term rates rose over the course of the summer. However, at the conclusion of their September meeting, the Fed committee decided that economic data is not strong enough to warrant tapering, and left the QE bond buying pace at the current $85 Billion/month.

We remind investors that tapering is not the same as a tightening of monetary policy. The overall Fed stance is likely to remain accommodative for the near to intermediate term, which is supportive of economic growth. And finally, a Fed exit from the markets means that the US economy has improved substantially to grow on its own, which should be good news for investors.

This normalization of economic conditions however may bring to slowly increasing interest rates over the next year or so. This will probably put some pressure of bond returns as reminder bond prices tend to fall as interest rates increase. Therefore we continue to recommend that investors should focus on slightly lower duration in their portfolios, with an overweight to credit-sensitive (corporate and high yield) bonds, as well as an overweight to floating rate bonds.

This information compiled by Cetera Financial Group is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The information has been selected to objectively convey the key drivers and catalysts standing behind current market direction and sentiment.

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